Banana Republic!

BIG PICTURE - The US is widely adored as the world's greatest empire,
yet few realise that the emperor has no clothes. As the masses look up to the
nation in admiration, they are fooled into believing that it is swimming in
wealth; the reality being that it is up to its eyeballs in debt. The US economy
is living on borrowed time and judgement day is inevitable. No nation in history
has ever managed to escape such economic imbalances and I suspect the US won't
get away with it either. Let's take a look at how this imaginary cloak has
been woven:

The economic recovery since the 2001 recession has been manufactured by excessive
credit-growth and consumption. For the first time ever, a central bank has
purposely engineered a credit bubble with the intention of bringing artificial
prosperity via rising asset-prices. The Federal Reserve dropped interest-rates
and the majority of Americans became the proverbial kids in the candy store,
unable to resist the temptation of cheap credit. This is evident from the fact
that over the past 6 years, US household debt soared from $6.99 trillion to
almost $12 trillion - a staggering increase of 70%! However, some economists
today discard this record debt-explosion as irrelevant because the net-worth
of US households over the same period has surged from $42 trillion to roughly
$54 trillion (largely due to the housing boom). In other words, due to rampant
credit and leverage in the economy, asset-prices have risen much more rapidly
than debt levels. But the key question is whether this is sustainable and at
what cost?

In my opinion, asset-prices can continue to rise for a long time if there
are willing borrowers and a central bank armed with an endless supply of credit.
However, you have to understand that rising asset-prices only give the illusion
of prosperity. The truth is that rapid monetary inflation and credit growth
always impoverish a society as money becomes abundant and therefore less valuable.
So, everyone may feel richer as their homes and stock portfolios appreciate
in value, but it'd be a mistake to confuse rising asset-prices in an economy
with real wealth creation. After all, wealth is a relative concept and if everyone
else's homes have also risen in value, how wealthy have you really become?

Given the levels of debt in the US, I have no doubt that the Federal Reserve
wants to keep the game going for as long as possible. It will achieve this
by continuing to inflate the supply of money and credit. Under this scenario,
the US dollar will surely depreciate against other major world currencies and
especially against precious metals whose supply can't be increased at the same
pace.

In order to assess the US economy's prospects, the most important issue to
understand is that the recent economic expansion hasn't been typical. The US
wage growth has been extremely poor and the capital spending by American companies
has also been dismal. In fact, real disposable income growth is now almost
zero and over the past 5 years, capital spending has increased by a paltry
12%. So far, the US consumer alone has carried the baton through record-high
indebtedness and consumer-spending; with home prices no longer appreciating,
you have to wonder where the future borrowing-power will come from.

In my view, the US looks more and more like a bubble economy, a banana republic
of some sorts, which is desperate for ever-rising asset-prices for its very
survival. Should American home and stock prices stall, let alone decline, the
fate of this great bubble will be sealed. Depreciating asset-prices will act
like a dagger in the heart of this artificial recovery, so the Federal Reserve
must continue to inflate at all costs.

Figure 1 clearly shows that in the US, the total debt as a percentage of GDP
is currently at an all-time high. It is worth noting that the last time the
US faced a meaningful contraction in debt relative to the size of its economy,
it coincided with the depression years of the 1930's. So, you can bet your
farm that Mr. Bernanke & Co. will try their best to avoid a repeat of such
a disaster by continuing to aid deficit spending through their ultra-loose
monetary policies.

Figure 1: Gigantic debt-bubble in the US!

Source: Ned Davis Research

With the US consumer leveraged to the hilt, the fate of the US economy now
lies with its corporations and its government. For sure, American companies
have recently registered great profits and are flush with cash, however so
far they haven't shown any willingness to spend their money - capital spending
is non-existent and wages haven't increased in line with the inflation-rate.
At least the American government has been more "responsible" by contributing
to the economy through the deficit spending program surrounding the various
wars being fought - albeit under false pretences!

CREATIVE ACCOUNTING - "Lies, damn lies and statistics" - Mark Twain

The world is littered with statistics which, more often than not, are misleading
and distort the truth. In this regard, the "official" statistics released by
the US establishment are no different. Take the US budget for example. The
budget reported in the media claims that the deficit was reduced to $319 billion
in 2005. However, the Financial Report issued by the Department of Treasury
says it was $760 billion, or over twice as large. "But how come?" you may wonder.
It is fascinating to note that the US budget process meant for general reporting
uses accounting procedures that ignore long-term, future obligations such as
Social Security and Medicare. The US keeps two sets of books, only wanting
the world to see one of them. The "President's Budget," issued by the Office
of Management and Budget and used to develop the annual budget, is based on
cash-accounting. The other set of accounts, the "Financial Report of the United
States," issued by the Department of the Treasury, uses a more realistic accrual-basis
accounting. It is interesting to note that the US Federal law requires ALL
businesses with revenues in excess of $5 million to use accrual accounting,
yet the budget figures released to the public don't follow this rule. Take
a look at Figure 2, which summarises the Financial Report issued by the US
Treasury taking into account the future obligations of the federal government.
According to this report, the US budget deficit is now at a record-high!

Figure 2: The real US budget-deficit!

Source: Department of Treasury, US

Next, let's review the strange US unemployment numbers released in the media.
Since the end of the recession in November 2001, reported employment growth
is up moderately, which makes it the worst performance during any post-war
economic recovery. However, closer inspection reveals that even this small
reported growth in employment is an absolute joke. The reported official unemployment
figures don't include those people who've given up looking for a job (due to
non-availability of jobs), joined a university or taken a part-time job since
they can't find full-time employment. When you add all these people, the real
rate of unemployment is closer to 10%.

Finally, the biggest "Cover-Up" award must go to the officials who determine
the Consumer Price and the Producer Price Indices (CPI and PPI). These "inflation-barometers" are
a total fraud! Remember, the Federal Reserve's biggest motive is to conceal
the ongoing inflation and manage the inflation expectations, or else the viability
of the Federal Reserve itself may come into question. Therefore, both the consumer
and producer prices are massaged, seasonally and hedonistically adjusted to
keep inflationary fears under check. So, by keeping the CPI and PPI artificially
suppressed via voodoo accounting and understating the inflation menace, the
Federal Reserve maintains the public's confidence in the US dollar as a great
store of value. After all, as long as the masses continue to believe in the "inflation-controlling" powers
of the Federal Reserve and the other central banks, the more inflation and
credit they can create!

In summary, the US economy isn't in good health and eventually the monetary
stimulus and injections of liquidity will fail to revive this terminally ill
patient. Accordingly, I advise you to minimise your exposure to American assets.
On other hand, tangible assets (especially precious metals) and mining stocks
represent a great opportunity for the medium to long-term investor. Despite
the recent pull-back, the long-term bull-market is still intact and I anticipate
a rally over the coming 6-8 months. Accordingly, this is an ideal time to add
to your positions in precious metals as well as mining and commodity-producing
companies.

The above is an excerpt from Money Matters, a monthly economic publication,
which highlights extraordinary investment opportunities in all major markets.
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Puru Saxena is the CEO of Puru Saxena Wealth Management, his Hong Kong based
SFC regulated firm which offers discretionary portfolio management and research
services to individual and corporate clients. The firm manages two trend-following
strategies - Discretionary Equity Portfolio and Discretionary Fund
portfolio. In addition, the firm also manages a Discretionary Blue-chip
Portfolio which invests in high-dividend world leading companies. Performance
data of these strategies is available from www.purusaxena.com

Puru Saxena also publishes Money Matters, a monthly economic report,
which identifies trends and highlights investment opportunities in all major
markets. In addition to the monthly report, subscribers of Money Matters also
receive "Weekly Updates" covering the recent market action. Money Matters is
available by subscription from www.purusaxena.com